Policymakers should be aware of any emerging stresses in the financial system, including those related to new instruments and institutions. Indeed, some central banks have created "financial stability" staff groups to oversee such monitoring and, in some cases, to publish regular financial stability reports. In the event that such monitoring suggests that the operations of some institutions or markets are under significant strain and, importantly, that the resulting pressures on businesses and households could have a material adverse effect on the real economy, the central bank may want to respond by adjusting the stance of monetary policy.

Financial firms may not consider the effects of their decisions on the stability of other firms or on the broader financial markets, and some may lack the incentives and ability to learn about and manage the risks induced by financial innovations. In such cases, policymakers may need to work with markets and their participants, and on occasion regulate them, to achieve the desired outcomes. However, policymakers should, wherever possible, avoid premature regulation that could stifle innovation.

Being the world's biggest debtor has its downsides. It puts us at risk that foreign investment desires may change, with potentially harmful effects on the stability of our financial markets. The best guess is that any such change would happen slowly given the reliance of other countries on U.S. imports for growth. But past experiences in other countries with large external deficits leaves one cautious about being too sanguine. Indeed, if our current account deficit continues to grow faster than GDP, there will be a continued deterioration in our net international investment position. That creates an obligation to pay increasing amounts to foreign owners of U.S. debts, and eats into our very ability to invest in our future.

These changes [in the U.S. and global financial system] appear to have made the financial system able to absorb more easily a broader array of shocks, but they have not eliminated risk. They have not ended the tendency of markets to occasional periods of mania and panic. They have not eliminated the possibility of failure of a major financial intermediary. And they cannot fully insulate the broader financial system from the effects of such a failure.

When innovation, such as we are now seeing in credit derivatives, takes place in a period of generally favorable economic and financial conditions, we are necessarily left with more uncertainty about how exposures will evolve and markets will function in less favorable circumstances.

The complexity of many new instruments and the relative immaturity of the various approaches used to measure the risks in those exposures magnify the uncertainty involved.

Adverse developments outside the banking system, such as the failure of a major nonbank financial intermediary, can potentially cause greater damage to the core of the financial system than might have been the case in the past.

Despite worrisome pockets of violence and destruction, commerce and wealth-building continues apace. On average, world standards of living are rising, in large part because of the widening embrace of competitive free markets, especially by populous and growing China and India. Since the autumn of 2001, global gross domestic product per capita has grown more than 8 percent. And growth in developing Asia, where so many of the world’s poor reside, has been considerably faster.

The Federal Reserve has important responsibilities for maintaining financial stability. That involves ensuring ex ante, that banks, for example, are managing their portfolios safely, that the clearing and settlement systems are well-designed and secure, that there are good arrangements in place for dealing with some kind of financial crisis, no matter what its source might be, and that, ex post, should there be a problem, that there be plenty of liquidity provided to the banking system and that the Fed would make sure that whatever problems arise be brought to some venue where they can be unwound and discussed and assistance be given.

I think it's very important to look at [option ARMs and other nontraditional mortgages]. And I believe that doing so would have on the margin some beneficial effects in reducing speculative activity in some local markets. However, overall, I think the main reason to look at these instruments is to make sure that banks are protected and that the consumers are protected against the potential risks of these instruments.

And, with respect to their safety, derivatives, for the most part, are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand them and to use them properly. The Federal Reserve's responsibility is to make sure that the institutions which it regulates have good systems and good procedures for ensuring that their derivatives portfolios are well-managed and don't create excessive risk in their institutions.

SEN. SARBANES: Warren Buffet has warned us that derivatives are time bombs, both for the parties that deal in them and the economic system. The Financial Times has said so far, there has been no explosion, but the risks of this fast growing market remain real. How do you respond to these concerns?

BERNANKE: I'm more sanguine about derivatives than the position you just suggested. I think, generally speaking, they are very valuable. They provide methods by which risks can be shared, sliced and diced and given to those most willing to bear it. They add, I believe, to the flexibility of the financial system in many different ways. And, with respect to their safety, derivatives, for the most part, are traded among very sophisticated financial institutions and individuals who have considerable incentive to understand them and to use them properly. The Federal Reserve's responsibility is to make sure that the institutions which it regulates have good systems and good procedures for ensuring that their derivatives portfolios are well-managed and don't create excessive risk in their institutions.

The U.S. financial system seems less vulnerable to specific shocks and better able to absorb larger shocks than was true in the relatively recent past. At the same time, however, changes in the structure of the financial system and an increase in product complexity could make a crisis more difficult to manage and perhaps more damaging...While the probability of a major crisis induced by the financial failure of a major institution may be lower, the damage associated with such an event could be higher.

We are significantly more dependent today on the confidence of the rest of the world in U.S. economic policy and the safety and stability of our financial markets. This gives us, along with the rest of the world, a compelling interest in sustaining credibility and confidence in U.S. financial management and the strength of our financial system.

Some argue that bubbles can be prevented or defused by financial regulatory initiatives. It is observed that asset bubbles have often been associated with rapid credit expansion, and hence it is claimed that restraining credit growth could quash nascent bubbles. A bubble could conceivably be defused by restrictive credit regulations that stifle economic growth. It is by no means clear, however, that such a regime would be more conducive to wealth creation over time than our current regulatory system. Also of relevance, in a vibrant financial system, such as exists in the United States, there will always be many avenues available to investors for financing a bubble. Furthermore, many analysts maintain that stocks are priced at the margin by institutions with little or no financing needs.